On October 13, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with The Union of the Comoros.1

Background

Economic growth has been weak and narrowly based, with average annual real GDP growth of 2¾ percent for 2001-05, well below the regional average. The poor growth record reflects some of the country's inherent disadvantages, such as the small size of the local market and the very high transport costs, but also a poor investment climate. Economic activity remains largely confined to subsistence agriculture, production of three export crops, import-related commerce, and government services. Fishing and tourism are well below potential; manufacturing is almost nonexistent.

Although almost half the population lives in poverty, other social indicators are more favorable than in most of sub-Saharan Africa mainly because of the low prevalence of HIV/AIDS.

With a very narrow export base, the economy is highly dependent on emigrants' remittances, which have financed consumer imports and provided a buffer against terms of trade shocks. Political instability and frequent interisland tensions that undermined institutional capacity led to a sharp reduction in donor assistance over the last decade. External debt is far above the threshold for the Highly Indebted Poor Countries Initiative (HIPC).

Membership in the franc zone arrangement has contributed to low inflation and limited fiscal deficits. Fiscal policy has been constrained by the large public wage bill, which limits the scope for social expenditure and public investment. Weak fiscal institutions have contributed to the chronic accumulation of expenditure arrears.

In 2005 macroeconomic stability was maintained despite a sharp deterioration in Comoros's terms of trade. Real GDP growth picked up thanks to services and tourism. Inflation was modest and rapid growth in remittances partly offset the sharp deterioration in the external trade balance. Fiscal performance improved in 2005, with an increase in the domestic primary surplus and a net reduction in domestic arrears.

Economic performance worsened in 2006, with a sharp economic slowdown and widening external imbalances. Public finances deteriorated significantly during the run-up to the May 2006 presidential elections. Fiscal revenues declined sharply, in large part due to pre-election governance problems in customs administration and public enterprises. Interisland coordination of fiscal policy was disrupted and expenditures were higher than expected. As a result, budgetary arrears and borrowing from the central bank increased substantially, and the domestic primary balance turned sharply negative.

The new government has taken steps to remedy the deterioration in public finances and restore interisland cooperation. The revenue-sharing mechanism was reinforced by ensuring that all revenues are channeled through a single account. The supplementary budget parliament approved in August contained a range of measures to boost revenues and curtail expenditures. The objective is to limit the full-year primary fiscal deficit to ¼ percent of GDP for the year as a whole while paying down the domestic arrears accumulated in the first half of the year.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. Directors welcomed the peaceful presidential elections in May 2006 as a milestone in the national reconciliation process. They saw the new government's most urgent economic task as correcting the recent deterioration in public finances, while launching a broader medium-term economic reform program to set the conditions for higher economic growth and poverty reduction.

Directors regretted the sharp deterioration in fiscal performance in the months leading up to the presidential elections, which resulted in large deviations from the first-half 2006 targets under the Staff-Monitored Program (SMP). They noted that weak inter-island cooperation and governance problems contributed to significant revenue shortfalls and expenditure overruns, resulting in a sharp accumulation of domestic arrears and debt.

Directors were encouraged by recent actions of the new government to restore inter-island fiscal cooperation, improve governance, curtail spending, and bolster revenue collection. They commended the authorities for making their policies transparent in a supplementary budget for 2006. This package of measures, in conjunction with financial support from donors, should help reduce domestic debt and arrears in the second half of 2006 and achieve a broadly balanced primary fiscal position for the year as a whole. A prudent 2007 budget should avoid new arrears and reallocate expenditure toward social sectors and public investment.

Directors noted that Comoros faces a daunting task of lifting economic growth after decades of stagnation. They welcomed the recent Interim Poverty Reduction and Growth Strategy Paper (I-PRSP), and supported its focus on fostering private-sector led economic growth and improving the provision of public services in the social sectors. To implement the strategy, Directors highlighted the need to enhance the capacity of public institutions, address the unsustainable debt burden, improve external competitiveness, and garner additional donor assistance, in line with pledges made during the December 2005 donor conference.

Directors cited Comoros's weak institutional capacity as a fundamental constraint on its growth and stabilization prospects. Insufficient cooperation between the Union and island governments, in the context of a decentralized fiscal system, had contributed to an excessively large civil service and weak fiscal policy implementation and statistical base. Directors also highlighted the adverse impact of institutional weaknesses on donor support and private sector investment. Going forward, they stressed that intensified inter-island cooperation and technical assistance, in particular in the fiscal area, will be essential for building institutions that can promote macroeconomic stability and growth.

Directors expressed concern about Comoros's lack of external competitiveness, and stressed the need for wide-ranging structural reforms. The recent real exchange rate appreciation and terms of trade shocks had contributed to widening external imbalances, although this mainly reflected structural factors. Directors noted that large inflows of remittances had so far kept the current account deficit in the moderate range, but stressed the need for vigilance and fiscal restraint. Directors recommended reforms to improve the investment climate, develop the financial sector, and reform public monopolies. In particular, Directors welcomed the authorities' plans to strengthen governance and introduce a new investment code. Improvements to transport and communications infrastructure will be critical for attracting foreign investors. Directors urged the authorities to accelerate efforts to prepare for greater competition and private ownership in sectors currently dominated by inefficient public monopolies, coordinating closely with the World Bank and other donors. They also underscored the importance of financial sector development for private sector growth and economic diversification, including the prospective entry of new banks.

Directors noted that successful implementation of the SMP in the second half of 2006 could open the way for a possible consideration of a PRGF arrangement as soon as practicable. To this end, they stressed the importance of focusing current policy efforts on restoring revenue collection, containing non-priority spending, and strengthening fiscal institutions to ensure that any PRGF-supported economic program would be rooted in sound fiscal policies. Directors acknowledged that the authorities have set ambitious program targets and that implementation risks will remain high. Directors welcomed the recent progress made by Comoros in reaching understandings with official creditors on clearing its large external arrears ahead of any PRGF arrangement, which in turn is a prerequisite for the eventual HIPC and MDRI debt relief necessary to reduce debt to a manageable level.

It is expected that the next Article IV consultation with the Union of the Comoros will be held on the standard 12-month cycle.

1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.